Brad Setser: Follow the Money2009-09-23T02:25:17Zhttp://blogs.cfr.org/setser/feed/atom/WordPressBrad Setserhttp://blogs.cfr.org/setser/?p=61832009-09-23T02:25:17Z2009-09-23T02:25:17ZMy post on the G-20’s agenda can be found on the official Pittsburgh Summit blog.
]]>19Brad Setserhttp://blogs.cfr.org/setser/?p=61252009-09-12T01:29:06Z2009-08-04T18:45:30ZThis will be my last blog post, at least for the foreseeable future.

I have accepted a new job, one that will require a certain level of discretion. I am excited by its challenges: ‘Balanced and sustainable” growth is something that I believe in. But suspending this blog is still hard.

I started blogging almost five years ago, back when blogging felt new and the barriers to entry were much lower. I was also lucky: first Nouriel Roubini and RGE and then the CFR were willing to pay me to, at least in part, write a niche blog on global imbalances and global capital flows. The CFR in general – and Richard Haass and Sebastian Mallaby in particular – took a risk (a calculated risk?) that I could maintain a blog with open comments that could live up to the standards of the Council on Foreign Relations.

I started writing a blog almost by default. There wasn’t an obvious source of demand for the kind of work that I wanted to do. My interests were too grounded in current events to fit well with academia, as I neither am a true economist nor a true political scientist. And I was too interested in policy issues to match, consistently, the interests of the market — especially as I am a bit better at seeing risks than opportunities. No private bank keeps a specialist on the TIC data on their payroll.

Plus writing a blog gave me the freedom to write what I wanted when I wanted – and on occasion to work from where I wanted to work.

Over time, I devoted more time to the blog and less to more academic publications than I should have. Blog posts “decay” faster than academic papers. At the same time, all my short-term incentives worked the other way: this blog’s traffic was never was all that high, but it still attracted more readers in an average week than have bought the book I wrote together with Dr. Roubini – and more readers than downloaded the paper I wrote exploring the strategic consequences of relying on foreign governments for financing.

This blog also had the unexpected virtue of making my work accessible to my parents, and convincing them – scientists both – that I did some real work, at least on occasion.**

A few commentators here have been around for a long-time; you will be missed. The comments section even helped to spawn a fewblogs. And I suspect that I may have been among the first to recognize that Felix Salmon would make an even better blogger than journalist.

Fundamentally this blog was about an issue – the United States’ trade deficit, the offsetting trade surpluses in other parts of the world and the capital flows that made this sustained “imbalance” possible. Most of my early blog posts argued, in one way or another, that taking on external debt to finance a housing and consumption boom wasn’t the best of ideas. Even if (or especially if) the deficit was financed by governments rather than private markets.

I always intended to write extensively about the world’s emerging markets. I never anticipated that I would end up writing most frequently about an emerging economy that I hardly knew when I first started writing this blog: China. Back in 2004, I was an expert on sovereign debt, not sovereign wealth. But some stories seize you. And China’s rise as a global creditor was just that story. I never thought China’s government would ever add close to $800 billion to its foreign assets over four quarters — accumulate close to $2,500 billion in foreign assets. China has stretched all definitions of the possible. There is – understandably – an enormous amount of interest in the consequences of a world where China is the world’s key creditor country; that, more than anything, seemed to drive this blog’s traffic.

I hope I did not stray too far from my initial vision – which was to write a blog that positioned the United States’ economy squarely in the global economy. Yet an international focus didn’t imply cheer-leading for all aspects of the contemporary global financial system. I never quite accepted that a world where the governments of poor countries finance some of the world’s wealthiest consumers really made all that much sense.

Above all, thanks to all who visited regularly, left comments, sent emails, linked here, recommended this blog or called me up to discuss something that they read here – and to those who helped find data, helped prepare graphs*** and filled in when I took a bit of time off. You all combined to make leaving this electronic space hard.

*I never managed to link to John Hempton or Antonia Fatas and Ilian Mihov– to name just two examples — quite as much as I intended. Hempton’s post on how banks fund current account deficits is a classic. And if I had kept blogging, I suspect I would have ended up linking to the IMF’s new blog rather frequently.
** It also confirmed my mother’s sense that I cannot spell.
*** The Council on Foreign Relations Center for Geoeconomic Studies will continue to track some of the variables that I have been following; bookmark “Geographics.”

]]>199Brad Setserhttp://blogs.cfr.org/setser/?p=61662009-08-05T12:54:38Z2009-08-04T18:41:43ZA quick chart showing how my estimates (from work I have done with Arpana Pandey of the CFR) for official holdings of Treasuries and Agencies compares with the FRBNY custodial holdings and the data that the US reports on the TIC website.

My estimates match those of the TIC in June of every year — when the data is revised. That is by design. All I am doing is using data on flows through the UK and Hong Kong to smooth out the revisions over the course of the year, and thus to avoid the sudden jumps in the official data.

Very few things rouse the rabble as much as an ideological debate. And over the past year it has been looking like we are having the beginnings of a nasty one in economics and finance. The current economic and financial crisis has shaken a few trees and made many go back and question first principles. Often, the answer is that the prevailing received economic and financial wisdom has fallen woefully short.

That said, those who are looking for a debate here may be disappointed. A narrow ideological debate is not the can I wanted to open up. Instead, I thought it would be useful to review from an historical perspective how we got here, and then address why this should matter.

For me, making the transition from economist to trader raised a lot of issues about efficient markets and animal spirits. It underscored the shortcomings of formal training and our incomplete understanding of the human element in finance and economics. As a result, the issue of paradigm shift has been simmering on my backburner for quite some time now.

One of the most important lessons I have learned as a trader is not just that emotions play an outsized role in market dynamics—that much became clear quite quickly—but that the emotions regularly swing, as if they were a pendulum, from one local extreme to the opposite. In other words, around any given trend there are oscillations above and below, moments of high bullishness and high bearishness. Time and time again we transition from moments when any positive statement is met with skepticism to moments when no one dares say anything negative. In short, we slowly change directions, see that the new direction starts to work and jump on, take the new direction too far so that it stops working, and then we start the whole process all over again.

These pendular swings in the market can take anywhere from a couple of weeks to numerous months, and they are marked by a distinct, three part psychological process: denial, migration, capitulation. In the first phase, participants deny that a change in market character is truly afoot. Markets rally on bad news (or sell off on good news) and traders look for others to blame for their trading losses (suggestion: when in doubt blame government; no one will ever disagree.) Then, little by little, traders begin to recognize ‘what is working’, start to question their previous beliefs, and then begin migrating from their old camp to the new. In the last phase, capitulation (or give-up phase), the final holdouts switch camps and jump on the new bandwagon—often in climatic fashion. This then completes the pendular swing.

This manifestation of human nature is not confined to intermediate term swings in the market. It also applies to ideological fashions in economics. At the time of the Great Depression the prevailing ideology was the Austrian Business Cycle School, a variant of the classical school of economics. (This school of thought was responsible for the useful term “creative destruction”). As the Depression took hold, the policy response was to allow the system to purge itself of its excesses. In retrospect, the mainstream view is that this policy response—or lack thereof—severely exacerbated the length and depth of the downturn.

Economists of every stripe have their own pet reasons as to what caused the Great Depression and what got us out of it. Leaving this debate aside, it is not controversial to say that Keynesian polices were perceived to have helped lift the US out of the Depression.

As a result of the belief that Keynesian policies ‘worked’, its adherents grew in number. The 50s and 60s were characterized by less faith in markets and more faith in government’s ability to solve problems. One might call this the ‘migration’ phase. By the time the 70s rolled around things had been taken even further, and we began to see wage/price rigidities and activist monetary and exchange rate policy take a serious toll. You could say people took a good thing too far.

The onset of the Reagan era marked the end of this pendular swing. Policies that placed greater faith in markets and considerably less in government, coupled with a more independent central bank, were perceived to have saved the economy from Keynesian excesses. As the economy grew over the course of the 80s, this new ideology—monetarist, supply-side, efficient market hypothesis—saw many new adherents jump on the bandwagon. By the late 90s/early 2000s, this prevailing ideology was scarcely seriously challenged. Markets were believed to be largely infallible and self-regulating, and no one doubted that everything government touched was going to be ruined. Fast forward to 2008: markets did fail, and the pillars of the existing ideological edifice started to crack. You could say people took a good thing too far.

Thus, the pendulum has started to swing again. Why does this matter? In short, we are going to be facing a lot of policy issues in the coming years, and many in markets, policy circles, and in the population at large are having a hard time getting off the paradigm. A lot of the baby boomers who learned their economics reading the Wall Street Journal editorial page in their formative years are still stuck in 1982. The high degree of residual ideology in the system is impeding, in my view, the fundamental rethink that the US needs at this juncture to get ahead and stay ahead of the rapidly moving global curve. In other words, with so many people still looking in the rearview mirror it increases the chances of car wrecks.

In my experience there is little room for ideology in economics. No set of rules or principles can fit all of reality for all points in time. The world to too complex and moves too quickly for this. The ‘perfect’ mix of markets and government is not a static concept. It is dynamic, and highly contextual. Again this post is not ideological. It is more a cautionary tale about human nature and the way we follow trends. We are trendy by nature. We stick with our old ideas for too long after the facts on the ground change. We then begrudgingly migrate to what appears to work, and, inevitably, take things too far. No amount of regulation can fix this; it can only mitigate the consequences from it. Let’s just hope that the amplitude of the next pendular swing is less extreme—but I suspect we are years, if not decades, away from worrying about it.

]]>27Brad Setserhttp://blogs.cfr.org/setser/?p=61272009-08-03T14:47:46Z2009-08-03T14:47:46ZOne of the biggest economic and political stories of this decade has been China’s emergence as the world’s biggest creditor country. At least in a ‘flow” sense. China’s current account surplus is now the world’s largest – and its government easily tops a “reserve and sovereign wealth fund” growth league table. The growth in China’s foreign assets at the peak of the oil boom – back when oil was well above $100 a barrel – topped the growth in the foreign assets of all the oil-exporting governments. Things have tamed down a bit – but China still is adding more to its reserves than anyone else.

Yet China is in a lot of ways an unusual creditor, for three reasons:

One, China is still a very poor country. It isn’t obvious why it makes sense for China to be financing other countries’ development rather than its own. That I suspect is part of the reason why China’s government seems so concerned about the risk of losses on its foreign assets.

Two, almost all outflows from China come from China’s government. Private investors generally have wanted to move money into China at China’s current exchange rate. The large role of the state in managing China’s capital outflows differentiates China from many leading creditor countries, and especially the US and the UK. Of course, the US government organized large loans to help Europe reconstruct in the 1940s and early 1950s, and thus the US government played a key role recycling the United States current account surplus during this period. But later in the 1950s and in the 1960s, the capital outflows that offset the United States current account surplus (and reserve-related inflows) largely came from private US individuals and firms. And back in the nineteenth century, private British investors were the main financiers of places like Argentina, Australia and the United States. We now live in a market-based global financial system where the biggest single actor is a state.

Three, unlike many past creditors, China doesn’t lend to the world in its own currency. It rather lends in the currencies of the “borrowing” countries – whether the US dollar, the euro, the British pound or the Australian dollar. That too is a change from historical norms. Many creditor countries have wanted debtors to borrow in the currency of the creditor country. To be sure, that didn’t always work out: it makes outright default more likely (ask those who lent to Latin American countries back in the twentieth century … ). But it did offer creditors a measure of protection against depreciation of the debtor’s currency.

This system was basically stable for the past few years – though not with out its tensions. Now though there are growing voices calling for change.

China seems to be inching toward the position that those countries borrowing its funds should start to take on some of the risks that China’s government now assumes. The basic idea is simple: China keeps its lending, but gets a better renminbi returns while taking less (currency) risk. That, though, would be a fundamental change in the current international financial system. And it isn’t quite clear how China can change its external profile so long as it wants above all to maintain a peg to the dollar at a level that requires sustained intervention – and a controlled capital account.

Some of China’s borrowers, by contrast, are arguing that maybe China shouldn’t be quite so keen to lend the world quite so much …

A score of recent reports have put the total assets managed by sovereign wealth funds at around $3 trillion.That seems high to us – at least if the estimate is limited to sovereign wealth funds external assets.

We don’t know the real total of course.Key institutions do not disclose their size – or enough information to allow definitive estimates of their size.But our latest tally would put the combined external assets of the major sovereign wealth funds roughly $1.5 trillion (as of June 2009) – rather less than many other estimates.This portfolio of $1.5 trillion does reflect an increase from the lows reached of late 2008.But it is well below the estimated $1.8 trillion in sovereign funds assets under management in mid 2008.Significant exposure to equities and alternative assets like property, hedge funds and private equity led to heavy losses by most funds in 2008 – a fact admitted by many of the managers.

$1.5 trillion is lot of money.But it is substantially less than $7 trillion or so held as traditional foreign exchange reserves.

There are three main reasons for our lower total.

First, we continue to believe that the foreign assets of Abu Dhabi’s two main sovereign funds – The Abu Dhabi Investment Authority (ADIA), and the smaller Abu Dhabi Investment Council (which was created out of ADIA and manages some of ADIA’s former assets) – are far smaller than many continue to claim.*Our latest estimate puts their total size at about $360 billion.That is roughly the same size as the $360 billion Norwegian government fund – and more than the estimated assets of the Kuwait Investment Authority (KIA) and the combined assets of Singapore’s GIC and Temasek.Our estimate for the GIC’s assets under management is also on the low side.

To be sure, Abu Dhabi’s total external assets exceed those managed by ADIA and the Abu Dhabi Investment Council. Abu Dhabi has another sovereign fund – Mubadala and a number of other government backed investors.Its mandate has long been to support Abu Dhabi’s internal development (“Mubadala [was] set up in 2002 with a mandate not only to seek a return on investment but also to attract businesses to Abu Dhabi and help diversify the emirate’s economy) but it now has a substantial external portfolio as well.Chalk up another $50 billion or so there.Sheik Mansour’s recent flurry of investments also has made it clear that not all of Abu Dhabi’s external wealth is managed by ADIA, the Council and Mubadala.The line between a sovereign wealth fund, a state company and the private investments of individual members of the ruling family isn’t always clear.Abu Dhabi as a whole likely has substantially more foreign assets than the $400 billion we estimate are held by ADIA, the Abu Dhabi Investment Council and Mubadala. And despite Dubai’s vulnerabilities, it still holds a good number of foreign assets, even if its highly leveraged portfolio has suffered greatly in the last year.

Two, the dividing line between China’s sovereign fund and China’s state banks isn’t totally clear.We opted to exclude the CIC’s domestic investment in the state banks from our total, as we focus on sovereign funds external assets.That is conceptually clean.But it ignores the fact that the state banks were recapitalized with foreign assets and thus manage a substantial foreign portfolio of their own.If the state banks foreign portfolio and those of the investment companies is added to the CIC’s foreign portfolio, the foreign assets of China’s sovereign funds exceed the CIC’s nominal $200 billion in size (The PBoC reports that the state banks had $220 billion of foreign assets at the end of Q1, with $120 billion in foreign portfolio investments and another $100 billion in business with offshore counterparties).

Three, we would argue that stabilization funds that are managed by the central bank and counted as part of the country’s reserves should be considered reserve assets – and not included in the total for sovereign funds.Russia’s reserve fund is a case in point.Its mandate precludes investment in anything other than classic reserve assets – and it thus has a more conservative portfolio that many central banks.We would also include SAMA’s foreign assets as “reserves.”If it walks like a duck (is managed by the central bank) and quacks like a duck (is invested predominantly in traditional reserve assets), it is a duck … While SAMA’s portfolio does include equities, so do some other central banks.

Those two pools add up.Russia had –at the end of June, a $85 billion in its stabilization fund and a $90 billion in a wealth fund (that is also managed for now by the central bank’s reserve managers). The Saudis have around $425 billion in non-reserve foreign assets (largely because the Saudi Treasury has substantial deposits with the central bank). But these pools are currently shrinking.The Saudi foreign assets fell by about $50 billion in the first half of 2009.Russia’s reserve fund will be depleted in 2010, if not before.Indeed, Russia’s current trajectory implies that its wealth fund – which was created to manage the surplus in its reserve fund – could also be exhausted in the near future.

Kazakhstan and Chile do not count their sovereign funds as part of their reserves.But their funds are mostly restricted to high grade fixed income, and they are also being drawn on to make up for 2009 fiscal deficits. Each count for about $20 billion

But the dividing line sometimes cuts the other way as well.The Hong Kong Monetary Authority has a substantial investment portfolio that isn’t invested in classic reserve assets.And Jamil Anderlini has reported that up to 15% of SAFE’s portfolio was – at least at one time – invested in risky assets.That puts SAFE’s “investment portfolio” at around $300 billion (though SAFE likely has substantial unrealized losses on this part of its portfolio, so its market value is likely less than this).If SAFE’s investment portfolio were to be considered separately, it would already be roughly the same size as many large sovereign funds.

Sum it all up and the pool of assets managed by sovereign funds and central banks that is currently invested in risky assets is around $2 trillion. And in a lot of way the amount of money available for investment in risky assets by major sovereign investors is the most important concept; it really doesn’t matter that much if the investment is managed by a central bank or a sovereign fund.

Will this total rise rapidly?

Our best guess is that it will not.

Although reserve accumulation has resumed, it remains slower than in late 2007 and early 2008.Moreover, the crisis likely led many countries to conclude that they should take fewer – not more – risks with their reserves. And perhaps some countries with sovereign funds will conclude that they would have been better served by more conservatively managed stabilization funds.

The inflow into the main Gulf funds is likely to remain subdued.Most Gulf countries are exporting less oil and are spending more at home. Mega-projects aren’t cheap. $70 a barrel doesn’t necessarily imply the large inflows that ADIA and KIA received in 2006 and 2007.Moreover, the proliferation of new investment vehicles has also reduced the inflow into the traditional sovereign funds. Much of Abu Dhabi’s surplus may be flowing to the Abu Dhabi Investment Council and other direct investors like Mubadala or the International Petroleum Investment Company (IPIC).

But for every rule there is an exception.China didn’t have to dip into its substantial stock of reserves during the crisis – and it now clearly wants to support the direct investments of its corporations. Vehicles like the China Development Bank (CDB) should grow rapidly. The CIC wasn’t fully invested prior to the crisis – limiting its losses.It is now clearly shifting out of cash and money market funds into various “risk” assets.And if China’s government decides it wants to hold more market risk, it could easily redirect some of its new reserve growth into the CIC – or just authorize SAFE to take more risk.

Estimated Foreign Assets of Major Sovereign Wealth Funds

Dec-07

Jun-08

Dec-08

Jun-09

ADIA/ADIC

453

476

338

359

Mubadala, other UAE

30

40

45

50

Kuwait

259

286

225

230

Qatar

65

82

60

63

Total GCC

807

883

668

702

Norway

371

391

323

367

Kazakhstan

21

26

27

23

Libya

40

45

50

52

Chile

14

19

20

17

Total Oil and Commodity Funds

1253

1364

1089

1160

China

90

90

90

100

GIC

245

242

166

179

Temasek

75

85

55

65

KIC

18

25

25

28

Total Asia

428

442

336

372

Total Major Sovereign Funds

1682

1806

1425

1533

Reserve-like Funds

SAMA non-reserve + pensions

335

414

475

423

Russian Reserve Fund

157

130

137

95

Russian Wealth Fund

33

88

90

Total Reserve-like Funds

492

577

700

608

All told, though, we still aren’t convinced that sovereign funds are quite as big as some have suggested – or are likely to grow all that fast in the next year or so.And for that matter, some funds may have been used heavily to support local markets and local firms, and thus may have fewer external assets than we estimate. It isn’t quite clear, for example, how the Emirates central bank financed its purchase of the large bond Dubai issued to raise emergency cash.

Then again, forecasting is hard.Forecasts that sovereign funds would swell rapidly were made just before the crisis dramatically reduced the size of many existing funds.If asset markets and oil prices soar, all bets are off.

A methodological note: Unless other information is available, we assume that these funds fared no better or worse than other investors with similar asset allocations (our estimates are based on the performance of prevailing benchmarks – see more on our methodology here). However, based on information from some funds, we did assume that a smaller share of new capital flowed into the heaviest hit risky assets in 2008.

“The Abu Dhabi authority, like all global investors, has also been hit by the world economic downturn, as well as lower oil prices — and it has tended to have a much larger position in equities, especially those in emerging markets, than other funds.
Brad W. Setser, an analyst at the Council of Foreign Relations, estimates that the Abu Dhabi fund lost more than 30 percent last year, bringing its size down to about $300 billion from a peak of $480 billion — a figure that is much lower than some of the larger public estimates and one that executives within the authority acknowledge is closer to the truth.”

The FT’s Andrew England also has used an estimate for ADIA that is more line with our estimates, reporting in December 2008 that “ADIA’s assets are estimated at $450bn-plus and traditionally its income has been reinvested in the fund, but it and the emirate’s other sovereign funds are believed to have suffered from the collapse in world equity markets.” That gives us hope we are not all off– but it is also isn’t definitive. We are always interested in other estimates, especially those that lay out the funds ADIA is estimated to have managed over time.

The most recent IMF article IV suggests that the UAE’s International Investment position was around $600 billion in 2007, roughly consistent with our estimates after accounting for the private wealth and other miscellaneous assets.

The UAE’s balance of payments data for 2008, incidentally, shows only $30 billion of outward flows from public investors – the line item that corresponds with sovereign funds.That isn’t any higher than in 2007 …

]]>8Brad Setserhttp://blogs.cfr.org/setser/?p=61342009-08-03T14:42:16Z2009-08-01T22:17:41ZThe Fed’s custodial holdings of Treasuries just topped $2 trillion. Custodial holdings of Treasuries rose by $25 billion in July. The overall pace of growth in the Fed’s custodial holdings did slow a bit in July, as some of the rise in Treasuries was offset by a fall in Agency holdings. But in a world where the US trade deficit is running at about $30 billion a month, a $15 billion monthly increase in the Fed’s custodial holdings is significant.

I understand why the Treasury market is so focused on Chinese demand — China is a the largest player in the market, and a major shift in Chinese demand would almost certainly have an impact. Right now, the market is obsessing over the low level of indirect bids in last week’s 2 year auction. At the same time, concern that central banks are abandoning Treasuries should be muted so long as the rise in the Fed’s custodial holdings of Treasuries is running far above the US trade deficit. Barring a huge increase in the trade deficit after May, that is certainly will be case over the last three months of data.

It is also true on a 12m basis.

The Fed’s custodial holdings may exaggerate central bank purchases a bit, as central banks sought safety in the crisis and moved funds out of private accounts. But so long as the custodial holdings of Treasuries are rising so rapidly, it is a little hard to argue that central bank reserve managers aren’t willing to hold dollars.

Central banks simply aren’t going to finance the entire fiscal deficit anymore. Not with the trade deficit so much smaller than the fiscal deficit. That’s a change. But in a lot of ways it is a healthy change: It is a sign that the US trade deficit is falling and the world is adjusting to a lower level of US consumption.

]]>6Brad Setserhttp://blogs.cfr.org/setser/?p=61322009-08-02T17:27:44Z2009-08-01T22:14:59ZQing Wang of Morgan Stanley: “Given China’s high national savings rate, from the perspective of the economy as a whole, there are only three forms in which China can deploy its savings: 1) onshore physical assets; 2) offshore physical assets; and 3) offshore financial assets. …. We therefore think that from the perspective of the economy as a whole, the opportunity cost of domestic fixed asset investment, or formation of physical assets onshore, should be the total returns on US government bonds. Put in simple terms, in the debate about over-investment at the current juncture, it actually boils down to an investment decision on building railways in China versus buying US government bonds, given China’s high national savings.

David Pilling: “Far from a sign of strength, Beijing’s accumulation of vast foreign reserves is the side-effect of an economic model too reliant on exports. The enormous trade surplus is the product of an undervalued renminbi that has allowed others to consume Chinese goods at the expense of Chinese people themselves. Beijing cannot dream of selling down its Treasury holdings without triggering the very dollar collapse it purports to dread. Nor are its shrill calls for the US to close its twin deficits – which would inevitably involve buying fewer Chinese goods – entirely convincing. Rather than exposing the superiority of China’s state-led model, the global financial crisis has laid bare the compromising embrace in which the US and China find themselves. ”

Philip Bowring on the obstacles (mostly self-created) to internationalizing the renminbi: “China’s expressions of desire to reduce the role of the dollar are anyway contradicted by its actual policy of maintaining a de facto peg to the U.S. currency, meanwhile continuing to accumulate dollars in reserves now totaling $2 trillion. The modest yuan appreciation after 2005 came to a halt more than a year ago as China has sought to sustain exports in the face of the global slump. There is conflict between macro-economic stabilization goals and pressures from industries and employment creation not to put more pressure on exporters. … Nor has there been any significant move towards full convertibility as the financial crisis has, with good reason, made the authorities nervous of liberalization …. any significant use of yuan requires and significant offshore stock of the currency. That is incompatible with China’s expressed desire to reduce its dollar reserve dependence.”

Michael Pettis on his blog and in the Financial Times: ” If the Chinese economy was the biggest beneficiary of excess US consumption growth, it is likely also to be the biggest victim of a rising US savings rate. … Eventually, and maybe this is already happening, the decline in the US trade deficit must result in a decline in China’s ability to export the difference between its growth in production and consumption. When this happens, China’s economy will grow more slowly than Chinese consumption, just as the opposite is happening in the US. Put another way, rather than act as the lower constraint for GDP growth as it has for the past two decades growth in Chinese consumption will become the upper constraint, as for the next several years Chinese consumption necessarily rises as a share of GDP, just as US consumption must decline as a share of US GDP.

And Paul Cavey on China’s credit boom — which clearly jump-started China’s economy in the second quarter.

And John Makin’s evaluation of the risks associated with China’s stimulus program. Makin and Pettis don’t seem all that far apart: Both worry about efforts to support production in anticipation of future demand, and worry about the impact of rapid money and credit growth of China’s long-run economic health.

Free exchange claims that many things you know about China are wrong, specifically arguing against the notion “China depresses domestic demand to boost its exports” as Paul Cavey forecasts that “China’s current-account surplus will fall to under 6% of GDP this year and 4% in 2010, down from a peak of 11% in 2007. Exports amounted to 35% of GDP in 2007; this year … that ratio will drop to 24.5%.” There are other forecasts that suggest a smaller fall in China’s surplus (it is down in q2 09 v q2 08, but is still running at roughly the same level as in 2008 in nominal dollar terms), but projecting some fall in China’s surplus isn’t unreasonable in a “rebalancing world.”

Let’s be clear here though. No one is arguing that China is currently limits domestic demand to support its exports; China is currently stimulating domestic demand. The question is whether or not Chinese policy makers took steps to depress domestic demand back when net exports were contributing 2 percentage points or more to growth, bring China’s surplus up to that 2007 peak. And on that point, I don’t think there is much room for debate. Fiscal policy was tight — look at the data on the central government’s fiscal balance from 2004 to 2007, and the large deposits that the government built up over this time. More importantly, after 2003, the government reigned in bank lending with administrative limits on loan growth and high reserve requirements. As a result — according to the IMF data — China entered into this crisis with one of the lowest loan to deposit ratios in the emerging world. That, in turn, gave China greater capacity to stimulate than most, as it could simple take its foot off the brakes it was applying to the banking system.

China is not currently suppressing domestic demand. But back when exports were booming China opted to limit inflationary pressures with a range of policies to limit domestic demand growth rather than allowing currency appreciation (yes, the RMB appreciated v the dollar after 2005, but that appreciation came when the dollar was generally depreciating v many currencies). Look back at China’s policy choices back in 2003/04, when a lending boom threatened to produce a sustained rise in inflation. There is a reason why China’s import growth didn’t keep pace with China’s export growth from the end of 2003 to the end of 2006. See the data in this post; there is a clear dip in import growth in 2004, one that coincides with China’s decision to limit bank lending.

I agree though with other argument that Free exchange (drawing on the Economists’ coverage of China) makes, namely that China’s export boom was capital rather than labor intensive, and didn’t generate all that many jobs. That is one reason why labor income slid relative to GDP during China’s boom.

]]>27Brad Setserhttp://blogs.cfr.org/setser/?p=60902009-08-01T16:07:29Z2009-07-31T19:34:45ZThis post is by Brad Setser and Paul Swartz of the Council on Foreign Relations.

No doubt today’s GDP release will attract the lion’s share of the econoblogosphere’s attention. But sometimes it is a good idea to counter-program.

Paul Swartz, I and others at the Council’s Center for Geoeconomic Studies have been – at the prodding of our boss – trying to come up with indicators that capture “Geoeconomic” risk. Or at least to develop measures some key “geoeconomic” concepts, with geoeconomics defined as anything that touches on both the economy and geopolitics. An example might be the gapminder chart we did for the Council’s multimedia spectacular on the financial crisis that touches on the question of whether the G-7 still brings together the world’s most economically powerful countries.

I am not sure that we have succeeded, though I do think we have come up with some interesting ideas – ideas, though, that need to be stress tested with a bit of external scrutiny. Call this a very rough working draft.

One idea has been to look at what share of the world’s total economic output is produced by democratic countries. To do this, we weighted output by a measure of a country’s political openness (from the Polity IV project). A low score implies that all of the world’s output is produced in countries that are not democracies. A high score means all the output is produced by countries that are well-functioning democracies. And a score in the middle means something in the middle – either there are a lot of economically large democracies and a lot of economically large autocracies, or that a lot of global output is produced by countries that aren’t total autocracies nor perfect democracies.

The results are interesting; the end of the Cold war increased the share of output produced by the world’s democracies. But China’s ability to grow rapidly with significantly democraticizing has made the global economy a bit less “democratic” (in the sense that less of the world’s output is produced by democracies).

That implies that if current economic trends – meaning the gap between the rate of growth between autocratic and more democratic countries — continue, the share of global output produced by democracies will decline over time.

Why does the “politics” matter — two potential reasons:

First, democracies are likely to prefer a world populated by other powerful democracies to one that is not. And second, democracies allow for peaceful political transitions; they are less brittle than autocracies — and thus arguably more stable, economically and politically.

Geostrategists are also interested in how concentrated economic power. Paul came up with a measure of that, one that looks at the distribution of global economic output (actually the distribution of output over a basic threshold for poverty, so if one country is rich and the rest are poor, we assume that power is concentrated not dispersed). The United States’ economic rise in the twentieth century (prompted in part by wars in Europe) had the effect of concentrating economic power. The rise of the BRICs by contrast has had the effect of dispersing power (some might call a greater dispersion of economic power a kind of democracy … ).

Our other ideas are variants, in some sense, of the first idea.

We compared the share of global oil output produced by democracies to the share of global economic output from democracies. While most global output is produced in democracies, most oil isn’t – and most oil exports come from non-democratic states.

It is interesting though that the share of oil exporters coming from democracies rose after 73; increasing the price of oil made production in the North Sea attractive – and Mexico’s oil exports rose along with its democracy score. That trend though also changed a bit recently.

And finally, we looked at global reserves and the global flow of funds. Reserves are rising relative to world GDP – and most reserves are still held by democracies (if we counted the assets of sovereign funds, the graph wouldn’t be as favorable to democracies).

But recently reserve growth has been weighted toward countries with low scores on a democracy index.

And it turns out that if you weight the global current account surplus by a countries political regime, the surplus countries are significantly less democratic than the deficit countries. In broad terms, non-democracies now finance democracies. The result here is sensitive to whether or not the eurozone is treated as a single unit or a set of different countries.

Three questions:

Do our indicators make sense?

Are they at all useful and interesting?

Are there better avenues/ approaches to try? Different types of risks that are worth tracking?

]]>46Brad Setserhttp://blogs.cfr.org/setser/?p=60562009-08-01T16:24:27Z2009-07-30T18:06:32ZIt is now rather common to argue that those economists who anticipated the crisis anticipated the wrong crisis – a dollar crisis, not a banking crisis. Robin Harding of the FT writes:

“If economists try to predict crises they will get it wrong, and that will reduce their credibility when they try to warn of risks. It was in their warnings that economists failed: plenty talked of ‘global imbalances’ or ‘excessive credit growth’; few followed that through to the proximate sources of danger in the financial system, and then forcibly argued for something to be done about it.”

“It’s interesting that he [Krugman] mentions Nouriel Roubini, who is one of several international economists who famously saw some sort of crisis on the horizon but who very much erred in guessing the precipitating factor. I think international macroeconomists have been looking for a dollar crisis for quite some time, and they believed that such a crisis would bring on the meltdown. Instead, the meltdown occurred for other reasons and paradoxically reinforced the position of the dollar (and, for the moment, many of the structural imbalances that have troubled international economists).”

Actually, the crisis has — at least temporarily — reduced those structural imbalances. The US trade deficit is much smaller now than before. And, be honest, the criticism directed at Dr. Roubini should have been directed at me: after 2005, the locus of Nouriel’s concerns shifted to the housing market and the financial sector, while I continued to focus on the risks associated directly with the US external deficit. But it is hard to argue against the conclusion that the current crisis stems, fundamentally, from the collapse in the financial sector’s ability to intermediate the US household deficit – not a collapse in the rest of the world’s willingness to accumulate dollars. The chain of risk intermediation broke down in New York and London before it broke down in Beijing, Moscow or Riyadh.

At the same time, I also think the argument that warnings about “imbalances” (meaning the US trade deficit) were wrong neglects one important thing: there was something of a balance of payments crisis in 2007, although it took a very unusual form. When US growth slowed and global growth did not, private investors (limited) willingness to finance the US deficit disappeared. Consider the following graph, which plots (net) private demand for US long-term financial assets (it is based on the TIC data, but I have adjusted the TIC data for “hidden” official inflows that show up in the Treasury’s annual survey of foreign portfolio investment) against the US trade deficit.

At the end of 2006, private demand for US portfolio investments disappeared. Net private flows, on a rolling 12m basis, went from around $200 billion to negative $350 billion. The gap between the trade deficit and private portfolio flows consequently became quite large. Close to a trillion dollars.

And that gap corresponded to weakness in one of the world’s few truly floating exchange rates (though PBoC and other big players no doubt have an impact of how the dollar floats against the euro).

What made up the gap, avoiding an outright crisis that would have forced the US to adjust far more rapidly? Truly unprecedented reserve growth – as private capital flooded emerging economies, including emerging economies with large current account surplus. That led to an extremely high level of official inflows into the US.

It is possible that the rise in official inflows drove up US market prices (and pushed down yields) and thus pushed private investors out of the US market. But the strong correlation between the fall in private demand for US assets and the dollar-euro suggest another dynamic was at work. Private investors shifted from financing the US to financing the emerging world, and emerging market governments channeled that flow back to the United States.

Nouriel and I clearly under-estimated the willingness of the emerging world to accumulate reserves and thus to finance a US deficit. Dooley, Garber and Folkerts-Landau got that right.

But the ability of the US to attract the external financing it needed to sustain its large deficit before the Fall 2008 crisis was – I would submit – a bit more of a dicey proposition than some commentary now suggests.

What did international economists and a host of others (look at the IMF’s 2007 report on the United States) really get wrong?

They thought the rise in foreign demand for US corporate bonds (a category that includes asset backed securities, including “private mortgage backed securities”) meant that risk was truly being dispersed away from the heart of the American financial system. Few realized that a lot of the demand was coming from SIVs sponsored by US institutions — and that a host of European banks with large dollar balance sheets (often managed in London) had effectively become part of the core of the US financial institutions.